Flip the Retail Script

The shift in consumer behavior toward embracing e-commerce — which now accounts for about 9 percent of all retail sales, according to the U.S. Census Bureau — has been a dominant trend in this economic cycle. And the trend toward online purchasing has forced retailers to cut back on the number
of their physical locations.

This has created a massive problem for mall owners and investors, particularly those with Class B and Class C properties. For commercial mortgage brokers and their clients, it is time to consider repurposing vacant space in order to boost net operating income and increase
foot traffic for the remaining tenants or owners.

Reductions of physical retail locations have been particularly acute among big-box retailers and department stores that often serve as anchor tenants for malls. Retail vacancies have remained stubbornly high and absorption has been tepid, despite a strong economic cycle. Any sort
of cyclical weakness would only make the issue more acute.

Vacant space is proving nearly impossible to fill with other retailers, especially as demand remains weak. The loss of an anchor tenant can trigger clauses in other tenants’ leases, allowing them to leave or seek better terms, further exacerbating the problem for a mall owner.

The timing of the decision to repurpose mall space will vary depending on the property’s capital structure, debt levels and location. Another factor is whether or not the local community or municipal government is applying pressure to repurpose the space. If so, owners and investors should
know if rezoning options will be made available. Retail properties typically generate more tax revenue than their residential counterparts, thus making them more attractive in the eyes of municipalities.

Leverage technology

The higher the debt load for a retail property, the quicker the decision to repurpose the space needs to be, since the need for cash flow is paramount for meeting loan obligations. If a fast decision is necessary, however, this also limits the available options, as redevelopment into a hotel
or some form of multifamily housing will likely require rezoning, demolition and significant construction. This can take years and a significant in-flow of capital.

In many cases, all parties involved would likely be better off if the owner sold the retail property to a developer or larger owner who is willing and able to assume the risk of such an undertaking. The same holds true if the owner is a smaller local investor or real estate fund, as it likely
represents an outsized portion of their portfolio. They may not be able to bear the risk or required capital for extensive redevelopment.

“ The timing of the decision to repurpose mall space will vary depending on the property’s capital structure, debt levels and location. ”

Considering the downward trajectory of the retail segment, it’s clearly desirable for any redevelopment campaign to begin in a timely fashion. Financing is one of the common sticking points for commercial real estate transactions, and with subpar-performing retail properties, it can be
particularly challenging to secure a purchase loan. Technology has made inroads in all aspects of real estate execution and transactions, and it can also help commercial mortgage brokers and retail-property investors close deals when time is of the essence.

In a recent example that showcases the power of online financing solutions, a technology-enabled direct lender funded a $3.3 million bridge loan for the purchase of a 27,000-square-foot retail center in the Northeast. The transaction originally took place through a live online auction,
with the winning bidder planning to secure their own financing.

When the intended lender could not close the deal in the allotted time, however, the technology-enabled direct lender stepped in with the competitive 53.3 million loan offer and worked with the auctioneer to close the escrow account within 14 days. As more and more retail properties come on
the market, technology is likely to emerge as a key solution for bridging the gap with necessary capital to reposition or create larger investment opportunities.

Choose an approach

In cases where a retail property’s existing owner or new owner chooses to redevelop the asset, repurposing to multifamily housing seems like the best use based on real estate fundamentals. According to Reis Inc., apartment vacancy rates are at 4.5 percent, near the low point for this cycle,
and effective rent prices grew 3.3 percent year over year as of fourth-quarter 2017. Additionally, single-family housing inventories are at multi-decade lows, with millennials still trickling into the market.

Once completed, a residential foothold brings a certain amount of permanent foot traffic and population in direct proximity to the remaining retail space. For this to be a viable path, however, the property must be near highways or mass transit that will make commuting to a central business
district or another job center possible.

“ A residential foothold brings a certain amount of permanent foot traffic and population in direct proximity to the remaining retail space. ”

Hotel fundamentals also are at strong levels, with occupancy rates and revenue per available room (RevPAR) in many markets at historical highs. Hotel-supply additions are beginning to percolate in many markets, however, and could put redevelopment at a disadvantage. While repurposing to
multifamily requires infrastructure nearby to make commuting easy, hotel properties need easy access to airports, convention centers or some sort of tourist or business-development destination. Similar to multifamily, repurposing from retail to hospitality also requires rezoning, demolition and a
large redevelopment undertaking, making it a higher-risk path.

On the other hand, repurposing to medical-based retail often does not require rezoning and simply means revamping the existing space, an option more likely to be financially supported by existing lenders or smaller owners. A mall in the Southeast recently repurposed space formerly occupied by
a department-store anchor into a university-operated health clinic, for example. The property is located near highways and decent population density, making this a viable option. Locations that are more remote are unlikely to attract foot traffic just because they add medical retail, mainly due to the
fact that most people will not travel long distances when they are not feeling well.

In order to aid this process, commercial mortgage brokers can focus on several key questions: How leveraged is the retail property? Does it need immediate cash flow to avoid delinquency? Who owns the property and is it a large portion of their investment portfolio? How strong is their capital
position? Does redevelopment make sense in this particular case? Is there easy access to transportation and business centers? Will the city support rezoning?

• • •

Repurposing retail space is a decision tree that many property owners and lenders are likely to confront in the coming years as e-commerce sales increase, Class B and C retail properties become increasingly less viable and demand for space in other property segments continues to grow.
It is likely that many of these properties will wind up being repurposed in the coming years, but figuring out the proper use remains a delicate issue to address.

Christopher Muoio is a senior quantitative strategist with Ten-X Commercial. His primary responsibilities include thought leadership, macroeconomic analysis and forecasting, and commercial real estate fundamentals analysis and forecasting for more than 50 major U.S metro areas. He serves as Ten-X Commercial’s primary hospitality-sector analyst and is responsible for his research team’s monthly employment-sectors report. Reach Muoio at cmuoio@ten-x.com.